Monday, February 2, 2015

The Looming Debt Crisis in China

A recent report by the Centre for Economic Policy Research and the International Center for Monetary and Banking Studies examines the growing level of debt in the world's economy.  While debt growth in the world's developed economies has levelled off since 2007:

...the same cannot be said for the world's emerging economies which have shown steady debt growth:

For many emerging economies, the debt crises that took place during the 1990s resulted in some nations taking steps to limit debt growth levels at the same time as they accumulated significant reserves of foreign currencies.  This allowed these economies to weather the 2008 - 2009 storm much better than their developed economy counterparts.

Unfortunately, the global economic slowdown during the Great Recession had a strong impact on exports to developed markets; this export slowdown led to governments engineering increasing domestic demand for their own goods which has resulted in very significant expansion in the level of domestic credit, particularly in China.  Thanks to the near-zero interest rate policies of the developed economies, there has been an increase in debt issuance by corporations in emerging economies through the bond market rather than through the international banking system.  The result has been that the ratio of total debt in emerging economies, excluding the financial sector, has risen by a whopping 36 percent since 2008.  The looming debt crisis in the world's emerging economies is most critical for China along with the "fragile eight" which includes Russia, Argentina, Brazil, Chile, India, Indonesia, South Africa and Turkey.  For this posting, I am going to focus on the debt issues facing China.

Let's look at the concept of a "leverage cycle".  Here is a diagram that shows the sequence of events that occur during a leverage cycle:

Each box in the diagram denotes a specific episode in the innovation cycle.  The cycle begins with a technological, financial or legal innovation (i.e. the expansion of railroads, the advent of radio and television, the invention of the computer, the unlocking of equity in homes, joining the World Trade Organization (i.e. China) etcetera).  These innovations result in optimism among governments, consumers and corporations which leads to an expansion of the amount of debt that each group is willing to take on since people, corporate leaders and governments feel that they are able to pull future income forward through borrowing to consume today because they are confident that they will be able to repay their debt.  Unfortunately, as time passes, the absorption of new technology slows as returns diminish, eventually resulting in slowing growth prospects.  At that time, the ability of the government, consumer or corporation to service its debt declines and there is a scaling back of the amount of credit that can be sustained.  The biggest problems occur when the reduction in debt capacity ends up being lower than current debt levels.  This means that the excessive optimism that resulted from the innovation has caused over-borrowing and that the capacity to repay the debt is questionable and results in either a debt crisis which could occur through either a debt default or slow deleveraging or complete structural reforms.  This cycle has been repeated throughout history; the post-Second World War Japanese economy is a prime example.  Ireland in the first decade of the twenty-first century is another example of the result of over-exuberance in the technology sector.    The authors also note that China could be following the path of its developed economy counterparts.

China has, in large part, been the economic engine of the world over the past decade.  It's seemingly endless ability to grow at levels that are nearly double that of the developed economies is stunning as shown on this bar graph:

The authors observe that China's economy is representative of the leverage cycle and that its current position in this cycle make it one of the candidates for the next episode of the debt crises that have plagued the world's economy since the 1990s.

As a bit of history, China acceded to the World Trade Organization in December 2001 after fifteen years of negotiation, much to the delight of the  world's advanced economies who could see only one thing; a massive market for their own goods.  This is when China entered the innovation part of the leverage cycle.  However, as it turned out, China protected its own interests through manipulating the value of its currency which allowed it to export its own cheaper goods to the world.  This resulted in a long string of trade deficits with many nations, most particularly the United States.  In fact, on average, since 2001, the U.S. - China trade deficit has grown by an average of 13.6 percent annually.

Here is a graphic that shows both real and nominal GDP growth for China since 1991:

The strong growth in the first half of the first decade of the 21st century is consistent with both demographic and productivity growth.  During this part of the cycle, debt levels in the Chinese economy were relatively stable.  When growth started to fade because of dropping demand for its exports during the 2008 recession, China was also facing two additional problems; a drop in the productivity boost that had been created by China's accession to the WTO as shown on these graphics and a changing demography:

You will note that the aging workforce issue that created problems for Japan's economy over the last two decades is very similar to the problem facing China's economy now.

Since 2008, China's total debt excluding the financial sector has increased by 72 percent of GDP or 14 percent annually as shown here:

This is almost double the rate of debt accumulation that both the United States and the United Kingdom experienced over the six years before the crisis of 2008.  The fast pace of China's debt accumulation means that the overall indebtedness of China's economy is now 220 percent of GDP, double the average of other emerging economies.

Here is a graphic that shows the breakdown of private sector and public sector debt:

The growth in private sector debt since the Great Recession is quite marked, especially  when it is  compared to the very modest growth in public sector debt.

China is facing a very toxic combination of a slowing economy and high and fast-growing levels of indebtedness.  It is quite likely that, over the coming years, China's economy will suffer as the nation faces growing difficulties in servicing debt, a problem that could be exacerbated if the global economy slips into another recession, particularly given where China's economy is in the leverage cycle.  Unfortunately, China's economy is caught between a rock and a hard place; the expansion of credit has been largely responsible for China's economic "miracle" and without significant growth in credit, the rate of China's economic expansion is likely to slow substantially which, in turn, will increase the inability of China's debtors to service their debt.  This will ripple through the world's economy, increasing the impact of a global economic slowdown just as the issue of over-indebtedness among developed economies magnified the Great Recession. 

1 comment:

  1. For a counterpoint to your argument, from the leading expert on the Chinese economy, Yukon Huang, take a look at this: